Public Company Boards and Management will be Affected by PCAOB’s New and Amended Auditing Standards Regarding Related Party Transactions, Significant Unusual Transactions and Financial Arrangements with Executive Officers

The PCAOB’s new and amended auditing standards, adopted on June 10 and subject to SEC approval, require that auditors, among other things, discuss related party transactions and executive officers’ financial arrangements with the appropriate board committee, and ensure that transactions are properly authorized and approved. The PCAOB has been considering the new and amended auditing standards since 2012, based on its conclusion that related party transactions, significant transactions that are unusual given their timing, size, or nature and financial arrangements with executive officers have been associated with fraudulent financial reporting and continue to pose increased risk of material error in financial statements. The heightened scrutiny that the new and amended auditing standards require is intended to promote a consistent approach to these critical audit areas that is comprehensive and integrated, is aligned with the PCAOB’s risk assessment standards, and is designed to address the risks of fraudulent and erroneous reporting about those transactions and arrangements.

With respect to audits of related party transactions, the PCAOB has explained that the new standard, which will supersede AU Section 334, differs from the existing auditing standard in that it requires auditors to conduct certain specified procedures “designed to assist the auditor in identifying red flags that indicate potential risks of material misstatements.” Auditors must evaluate both the accounting for and disclosure about related party transactions under the new standard. Among other things, auditors must inquire of the audit committee or its chair regarding “the audit committee’s understanding of the company’s relationships and transactions with related parties that are significant to the company” and obtain information regarding concerns of any member of the audit committee about any company relationships or transactions with related parties. The auditors must also report to the audit committee about their own evaluation of the company’s related party transactions.

With respect to significant unusual transactions, the amendments to the PCAOB’s existing Auditing Standards Nos. 12, 13, and 16 and to AU Section 316 are designed to improve the auditor’s identification and evaluation of a company’s significant unusual transactions. Most importantly, they require the auditor to understand the business purpose or (lack thereof) for such transactions. Similar to the related party standard, the new procedures are intended to assist the auditors in identifying red flags that suggest the potential risk of material misstatement because of the PCAOB’s view that transactions that are outside the normal course of business or that appear to be unusual because of their timing, size, or nature may be used to engage in fraudulent financial reporting or conceal misappropriation of assets. Among the various newly required procedures that will affect boards and their legal advisors are requirements that the auditor assess whether the transaction has been authorized and approved in accordance with the company’s established policies and procedures, including by reading board minutes, and whether the parties to the transaction have the necessary financial capability to enter into the transaction.

The amendments to the PCAOB’s existing Auditing Standard No. 12 require auditors to perform procedures to obtain an understanding of the company’s financial relationships and transactions with executive officers. These procedures are designed to enhance the auditor’s attention to incentives or pressures for the company to achieve certain financial performance metrics, given the important role of executive officers with respect to accounting or financial reporting decisions. The procedures will require auditors to speak to the chair of the compensation committee and any compensation consultants regarding the structure of the company’s compensation of executive officers and understand the incentive compensation arrangements, changes and adjustments to those arrangements and any special bonuses. In addition, the auditors must obtain an understanding of established policies and procedures regarding the authorization and approval of executive officer expense reimbursements. Although the existing standards require auditors to consider compensation arrangements with senior management, the amended standard is likely to enhance auditors’ focus on financial arrangements with executive officers.

The first pages of the PCAOB’s adopting release explain that the standards are intended to address concerns initially raised by the corporate scandals at companies such as Enron Corporation and Worldcom, Inc. and, more recently, by financial reporting scandals involving Chinese companies. Although the Sarbanes-Oxley Act of 2002 was enacted to address such scandals, the PCAOB’s standards reflect its view that heightened auditor scrutiny of these areas is necessary. Therefore, boards, management and auditors will need to consider whether they need to have more formal communications and processes to evaluate and address these critical areas.

The new and amended standards are expected to be effective for audits of financial statements for fiscal years beginning on or after December 15, 2014.